ESG's evolving role in structured finance unpacked

ESG is still a top priority within structured finance, despite competing concerns stemming from rising interest rates. Panellists at SCI’s ‘Unpacking ESG’ webinar last week affirmed the enduring importance of sustainability initiatives in the securitisation market to participants, even amid a recent lull in activity. However, while demand for ESG-linked securitisation may stand strong, precisely what ESG means for participants is no longer what it was.

“ESG is still, of course, a very hot topic for the whole debt capital markets, but unsurprisingly what ESG means for this market is also changing,” explained Begum Gursoy, director at Sustainalytics. “What was considered to be impactful a couple of years ago is not considered to be impactful today. So, while demand is strong, expectations are also getting more and more stringent, which also impacts the volumes.”

Sustainability-linked issuance has been dropping off not only in the securitisation market of late, but across the entire DCM universe. Of overall debt issuance, sustainable debt has accounted for around 13% of total issuance in recent years – a number projected to increase as the macroeconomic environment becomes more stable.

Securitisation is on a par with the broader debt capital market environment on the whole, although the situation does differ regionally. For instance, issuance of sustainable labelled bonds in APAC grew by 7% last year, numbers in EMEA dropped slightly and US corporates fell 47%.

Nevertheless, demand for sustainable-labelled bond issuance remains high across the board – with the latest sustainable issuances in the securitisation market still many-times oversubscribed, according to the panel. However, given the recent paucity in issuance, it was noted that it may be hard to distinguish investor interest in ESG principles from their interest in yield.

“It’s hard to disentangle how much interest there was in the ESG labelling of our bonds from the demand for anything that had yield when we were still at the zero boundary of interest rates,” stated Robert McDonough, director of ESG and regulatory initiatives at Angel Oak Capital Advisors.

Greenwashing dominated much of the ESG-related discussions last year, as conversations shifted away from minimum-criteria to hold an ESG label and towards how ESG investments fit into the broader climate change picture, as the likes of the 2030 Paris Agreement targets draw closer.

The shifting understanding of what ESG means within the market is expected to be a positive for future issuance, according to another panellist. In fact, the introduction of more stringent covenants is not anticipated to serve as a deterrent for future issuance, but rather an important step in making ESG offerings more robust and meaningful.

For the year ahead, political headwinds are now dominating sustainability discourse, with several major elections on the docket – including in both the UK and the US. However, panellists pointed out that despite differing attitudes towards ESG policy between Democrats and Republicans in the US, major ESG policies were rolled out under the last Republican administration.

McDonough observed: “If the current administration’s mandate is extended, that would obviously be favourable, but it’s not necessarily going to lead to an eruption in issuances of labelled products. It’s not a panacea for all the concerns out there, but it certainly would be a supportive environment for issuance.”

On the subject of ESG policy, the panel agreed that there seems to be a growing consensus across the market around the need to see greater standardisation of ESG disclosures instead of a greater reliance on labelling. “I think there’s a movement of ‘look, we can have a positive social or environmental impact, and here’s the way we can go about doing this without having to go to the extra step of labelling’,” McDonough noted. “Because at that point, you’re really sticking your head up above the crowd – and it feels like somebody is going to throw a rock at it in this environment.”

He continued: “You can still achieve the same things by having robust and, to some degree, independently validated data disclosures that let investors make their own minds up about this.”

The rising anti-labelling sentiment is not only driven by the fear of potential ESG backlash leading to reputational damages or litigation, but also by investor demand as they actively pursue real, positive impact on social and environmental issues.

The challenges posed by SFDR requirements in the absence of associated labels have been well documented. However, the categorisation of ‘how green’ a deal is has been rejected in the UK, where the government has instead opted for ‘investment-theme’ categories in its new SDR regime. Such robust parameters are considered to be an important improvement in the ESG-labelling universe – particularly the UK’s incorporation of a category dedicated to funding the transition.

“The opportunity around trying to fund the transition in some of these hard-to-abate sectors is not really covered by a lot of the frameworks that exist today. Some sectors are going to really find it hard and expensive, frankly, to transition to cleaner energy, so they are desperately going to be in need of this transitioning funding,” explained Becky Palmer, director of sustainable finance data at ICE Data Services.

She added: “So, finding a way to fund that without it looking like greenwashing is really important. There needs to be a realisation that having a portfolio full of green stuff isn’t actually helping the root problem.”

In fact, including a category encouraging the funding of the energy transition is not only important long term, but also particularly useful for promoting ESG-linked transactions in the present political landscape. Palmer continued: “Funding the transition is an excellent way to bypass the headline risk, but it’s associated with ESG certainly between now and the election. It can be a very useful way to think about how we’re trying to deploy capital in the marketplace, because a lot of the pushback and political headlines really come from the misconception that ESG investment is about denying money to oil and gas firms.”

Despite the challenges that remain, plenty of optimism was heard from the panel about the future of ESG in the structured finance market. Not only is there room for future growth when supplies increase, but there is also untapped collateral particularly in the social and transition securitisation sides of things.

“The main term and key concept here is integration. ESG is not a separate silo of the discussion; it is absolutely part of the business model or investment strategy. And the more that we treat it like that, the more it helps avoid box-checking and avoid greenwashing. The more we move towards that the better, and I think we are moving in that direction,” stated one panellist.

They concluded: “I think we’re on the right track, and I think it’s going to become a more lean-and-mean and efficient exercise as we get more integrated.”

Claudia Lewis

For more on all of these topics and others, attend SCI’s London ESG Leaders’ Securitisation Summit on 16 April.